Vanilla Barrier options

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    Stochastic Calculus,Spring 2013, Lecture 3

    Reading for this lecture:(1) [1] pp

    10!"11#

    (2) [2] pp 2#"31(3) [3] pp $#"$%

    &anilla 'arrier ptions n finance, a *arrier option is a t+pe of contract here option toe-ercise at .aturit+ depends on the underl+ing crossing or reaching a gi/en *arrier le/elhere are se/eral t+pes of /anilla *arrier options (/anillastands for si.ple and liuid on the.ar4et instru.ent) So.e 4noc4"out henthe underl+ing asset price crosses a *arrier (ie,the+ *eco.e orthless) f theunderl+ing asset price *egins *elo the *arrier and .ust crossthe *arrier a*o/e itto cause the 4noc4"out, the option is said to *e up"and"out 5 don"and"out optionhas the *arrier *elo the initial asset price and 4noc4s out if the asset price falls*elo the *arrier ther options 4noc4"in at a *arrier (ie, pa+off 6ero unless the+ cross a*arrier) 7noc4"in options also fall in to categories: up"and"in anddon"and"in he pa+off ate-piration is usuall+ a fi-ed a.ount, a call or a puthere are also .ore co.plicated *arrieroptions, for instance, R' (range in *ound) options hich for a specified financial inde-, forinstance 3".onth Li*or rate or 2" +ear C8S rate, pa+s a fi-ed a.ount .ultiplied *+ thefraction of o*ser/ations henthe inde- is inside a specified range

    Later in this lecture e treat the si.plest case 9e price an up"and"out optionhose pa+off ate-piration is a call and e assu.e that the stoc4 price is .od" elled *+ 'ronian .otion

    5ssu.ption that the stoc4 price can *e .odelled *+ 'ronian .otion is rather unrealistic as'ronian .otion (e/en ith large drift)can *e negati/e ith positi/e pro*a*ilit+ Later in the coursee ill *e a*le toappl+ si.ilar calculations for the .ore realistic case hen the asset price follosageo.etric 'ronian .otion

    Running .a-i.u. and first passage ti.e or a stochastic process ;t, t 0e define

    the running .a-i.u. as

    8t< .a- ;

    s (1)

    0st

    or this process to *e ell defined e assu.e that the process ;tis has continuous

    tra=ectories(in fact, e need onl+ ith pro*a*ilit+ one) Closel+ related torunning.a-i.u. is the first passage ti.e hich is defined as

    a< inf{t > 0 : ;

    t< a}, (2)that is for

    a fi-ed a ti.e a

    is the first ti.e hen ;treaches le/el a ro. the

    definitions it is clear that e/ents {a? t} and {8

    t a} coincide, ie,

    {a? t} {8

    t> a} (3)

    ro. the e-a.ples in the *eginning of the lecture one can conclude that the /alueof .an+*arrier options depends on the *eha/ior of the .a-i.u. asset price prior tooption e-piration,or eui/alentl+, on the distri*ution of the running .a-i.u. orinstance, the 4noledge of thedistri*ution of the running .a-i.u. (or eui/alentl+ of the first passage ti.e) is enough to

    co.pute the /alue of the si.ple 4noc4"in@outoptions1

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    2

    'ut it turns out that for a general stochastic process ;tthe distri*ution of

    the running .a-i.u. is rather co.plicated and often cannot *eritten out in a closedfor.

    'ronian .otion n the case hen stochastic process ;t

    is a 'ronian

    .otion e can e-plicitl+ calculate the distri*ution of the running

    .a-i.u. and hittingti.e

    heore. 1 (Reflection Arinciple) Let a > 0 hen A(a? t) < 2A('

    t

    > a)

    Re.ar4 2 'efore the start of the proof let us rerite the a*o/e euation as

    A(a? t) < 2

    2r

    e- @

    (2t)

    2Bta

    d- ()

    o find the pro*a*ilit+ densit+ of

    ae change/aria*les - a} is a su*set of the e/ent {

    a?

    t},thus

    A(a? t) < 2A(

    a? t, '

    t> a) < 2A('

    t> a) (%)

    E

    Re.ar4 3 rul+ spea4ing, the fact that 't '

    ais independent of F

    a

    (infor".ation a/aila*le at ti.e a) needs to *e pro/ed using the

    strong 8ar4o/ propert+for 'ronian .otion 9e refer to [2] for the

    proofne can go further and generali6e the result of 0heore. 1 Let u ? / a, thenusingthe reflection principle e can easil+ sho that

    A(a? t, u ? '

    t? /) < A(2a / ? '

    t? 2a u) (!)

    Since e/ents {a? t} and {8

    t> a} are eui/alent

    e o*tain

    A(8t> a, u ? '

    t? /) < A(2a / ? '

    t? 2a u) ($)

    Fo let the inter/al (u, /) shrin4 to -, so

    that1 2

    A(8t> a, '

    t< -) < A('

    t< 2a -)